7/15/2010 @ 1:20PM

Financial Reform, R.I.P.

So long Glass-Steagall. Hello Dodd-Frank–the most comprehensive rewrite of financial rules since 1933. This 2,319-page colossus–10 times the length of Glass-Steagall–took 1.5 years to produce and will cost $30 billion and many more years to implement. Will all this time and treasure make Wall Street safe for Main Street?

No.

Dodd-Frank is a full-employment act for regulators that addresses everything but the root causes of the financial collapse. It serves up a dog’s breakfast covering proprietary trading, consumer financial protection, derivatives trading, executive pay, credit card fees, whistle-blowers, minority inclusion and Congolese minerals. Dodd-Frank also mandates 68 new studies of carbon markets, Chinese drywalls, and person-to-person lending, and many other irrelevancies.

Root Causes

None of this deals with the central problem–Wall Street’s ability to hide behind claims of proprietary information to facilitate the production and sale of trillions of dollars in securities whose true values are almost impossible for outsiders to determine.

This policy of “systematic non-disclosure”–the absence of complete transparency about what financial firms really owe and are owed–left only its CEOs and their top consiglieres in a position to know what their companies really owned and owed. Consequently, the valuation of Wall Street firms came down to trusting the bank’s senior executives–those who often had the greatest stakes in the non-disclosure system.

As news of all this widespread Wall Street chicanery spread, investors eventually realized that the “grownups”–rating companies, boards of directors, regulators, and politicians–had been well-paid to look the other way. So public trust took a holiday. Wall Street’s house of cards collapsed, taking Main Street down in the process.

All this malfeasance was no organized conspiracy, but a self-organizing, automatically expanding gravy train. Its participants included many of the world’s largest and most prestigious banks, insurance companies, hedge funds, credit raters, law firms and accounting firms.

What share of financial institutions’ assets and liabilities were fundamentally toxic may never be known. But that is beside the point. With no way to independently verify, in real time, the precise nature of financial firms’ assets and liabilities, they are all vulnerable to panics by investors, counterparties, and depositors, based on rumors and speculation as well as fact.

The resulting serial collapse of Wall Street behemoths, in turn, led Uncle Sam to step in and issue his own brand of increasingly hard-to-value securities–some $24 trillion (according to Neal Barofsky, Congress’ TARP watchdog) in contingent guarantees to all manner of financial companies.

This is a colossal liability, almost twice U.S. gross domestic product. If another massive bank run hit Wall Street–say, next week–Uncle Sam would be forced to print trillions to cover these guarantees. The prospect of getting paid back in watered-down dollars might then lead people to run even faster to the banks, to get their money and buy something tangible before prices skyrocket. Ultimately, Uncle Sam’s guarantees are only worth what they are written on–paper.

So Uncle Sam didn’t lead us out of the woods; he led us deeper into the woods. While he (temporarily) saved Wall Street, he may have gravely endangered Main Street.

Meanwhile, many major players on Wall Street have been laughing all the way from their banks. One top banker after another has been able to leave office with their generous golden parachutes, starter castles and yachts intact.

In contrast, during the 1930s, Citibank’s CEO and the head of the New York Stock Exchange did serious jail time for financial peccadilloes; in the late 1980s, the S&L crisis led to more than 1,000 felony convictions. This time around, aside from blatant thieves like Bernie Madoff and “Sir” Alan Stanford, we’ve been more forgiving. Of course Dodd-Frank does instruct the U.S. Sentencing Commission to re-examine its guidelines for financial fraudsters, but sentencing presumes conviction.

Yet the real criminal that needs to stand trial is this: our phony system of systematic non-disclosure about what financial firms are really worth.

Pictures of Food

Dodd-Frank no doubt contains some useful provisions–inevitably, in a 2,319-page bill. Overall, however, this law is like being invited to dinner and served pictures of food.

Far from streamlining regulations, mandating greater transparency, and reducing uncertainty, Dodd-Frank provides government bureaucrats with unrestricted hunting licenses. Only one of the roughly 115 federal and state agencies currently involved in financial regulation has been consolidated. At the same time, the new law creates 12 new regulatory bodies and gives them vast amounts of rule-making discretion. In the next two years these and other financial regulators will hold an estimated 243 new rule-making procedures.

The new law still provides no single regulator for deposit-taking institutions. The SEC and the CFTC continue to share authority over derivatives. A toothless National Insurance Office will “gather information” from 50 state regulators; the Fed’s new Bureau of Consumer Financial Protection will have to tip toe around the SEC, the FTC, and the Federal housing agencies; a new SEC Credit Rating Agency Board will try to rate credit raters; the Fed also gets unfettered discretion to delay implementation of the Volcker Rule until 2023, and …. you don’t want to know.

Dodd-Frank is not just a prescription for regulatory sclerosis. It is a bonanza for Wall Street lobbyists and lawyers, who will help determine what this law’s 283,985 words actually mean.

In 1990-2009 Wall Street and its friends in the insurance and real estate industries spent an average of $2,973 (in 2010 dollars) per congressman and senator per day on campaign contributions and lobbying. All this spending kept full financial disclosure off the table and helped today’s top 10 financial giants to dominate the industry.

Paths Not Taken

In 1982 seven people died in Chicago from consuming Tylenol tainted with cyanide by some criminal who is yet to be caught. Overnight,
Johnson & Johnson
found no market for its global 30 million bottles of Tylenol. Talk about a toxic asset!

J&J recalled all 30 million bottles, threw them away, and replaced them with safety-sealed bottles. In so doing, it disclosed the contents to be Tylenol not cyanide. Its toxic asset problem was solved for good.

Dodd-Frank’s approach is different. This law is akin to J&J restocking the shelves with the same unsealed bottles, hiring thousands of people to randomly inspect drug store aisles in the hope of catching the miscreant, and contracting with funeral companies to quickly pick up the dead. Indeed, a major part of Dodd-Frank focuses on arranging speedier funerals for failing financial institutions rather than preventing such funerals in the first place.

Dodd-Frank also relies heavily on the failed “good bank”-”bad bank” model of regulation. In this model, “bad banks” that take extra risks will be allowed to fail, while “good banks” are protected.

Earth to Congress! We tried this in September 2008. “Bad bank” Lehman was allowed to fail, which blew up in Uncle Sam’s face.
Citigroup
, a “good” bank, would have failed but for a bailout;
Goldman Sachs
, a “bad bank,” might have failed had Uncle Sam not intervened indirectly.
AIG
wasn’t even a bank. But it was bad, and it was saved. When push comes to shove, this regulatory ring-fence never works.

The Right Financial Fix

Were we really serious about fixing our financial system, there’s a very simple alternative–Limited Purpose Banking. LPB would transform all financial intermediaries with limited liability into mutual fund companies. Under LPB a single regulatory agency–the “Federal Financial Authority”–would organize the independent rating, verification, custody and full disclosure of all securities held by the mutual funds.

Voilà, by dint of competition and transparency, “liar loans,” off-balance sheet gimmickry, and toxic assets would all disappear. LPB would let the financial sector do only what Main Street needs it to do–connect lenders to borrowers and savers to investors.

The financial sector’s job is not to take taxpayers to the casino and collect the winnings. This kind of “cowboy capitalism” is far too dangerous to maintain. But Dodd-Frank does precisely this, albeit with many more regulatory cops on the beat.

In contrast, LPB would put an end to Wall Street’s gambling with taxpayer chips. Since mutual funds are, in effect, small banks with 100% capital requirements in all circumstances, they can never fail. Neither can their holding companies. Under LPB, financial crises and the massive damage they inflict on the entire (global) economy would become a thing of the past.

Of course, there would be losers. Some Wall Street executives might have to find employment in Las Vegas or offshore banks. Some lobbyists, lawyers, credit analysts and accountants might need to find higher callings. Some politicians might even have to solicit more support from Main Street.

Alas, Dodd-Frank bears no resemblance to Limited Purpose Banking. But bad laws don’t always last, and this one may eventually lead us to LPB by showing us precisely what not to do–if we ever get another chance.